1. Managerial Economics Jack Wu
Externality
Managerial Economics
Jack Wu

2. Externalities one party directly conveys benefit or cost to others
positive
negative
benchmark: collective marginal benefit = collective marginal cost

3. Saks: Fifth Avenue vs Mall
Externalities
New York, NY: 611 Fifth Avenue
Stamford, CT: Town Center Mall
Chevy Chase, MD: 5555 Wisconsin Ave
McClean, VA: Tysons Galleria
(c) , Ivan Png
Hong Kong example:
Park ‘N Shop – inside shopping mall at Winsor House
Wellcome – along Great George Street (across street from Winsor House)
Saks has long history, good reputation, and advertises heavily; will attract business for neighbours;
on street, generates “externalities” for other businesses;
mall is owned and operated by single entity; if “anchor” store attracts business for specialty stores, management can charge higher rent to specialty stores and subsidize anchor tenant.
Worldwide trend: shops gravitating away from open streets and towards malls
Pashigian and Gould (1998): in the United States,
average department store rent = $2.24 per square foot;
after controlling for differences in sales per square foot, average speciality store rent = $11.88 per square foot.

4. Sak’s Positive Externalities15
13.4
group marginal benefit 10
Sak’s marginal benefit
(Hundred thousand dollars)
Marginal benefit/cost 9
florist’s marginal
benefit 4
profit gain from
additional investment
3.6
marginal
cost 1
0.8 1 5 9 10
shoe store’s
marginal benefit
Hundred thousand dollars of investment

5. Sak’s Negative Externalities10
marginal benefit
profit gain from
reducing investment
(Hundred thousand dollars)
Marginal benefit/cost
group marginal cost b a 2
Sol’s marginal cost 1
Sak’s marginal cost c 5
7.5 9 10
Hundred thousand dollars of investment

6. Silicon Valley Stanford University Xerox Palo Alto Research Center
Externalities
Stanford University
Xerox Palo Alto Research Center
Hewlett-Packard
Cisco Systems
3Com
Yahoo!
(c) , Ivan Png
Hewlett and Packard were inspired by Stanford Engineering Dean Fred Terman;
after HP formed, Stanford established Industrial Park -- capturing some externalities;
HP became one of first tenants
Xerox PARC was origin of many important inventions:
Windows interface and mouse – commercialized by Apple and then Microsoft
local area network – commercialized by 3Com
Venture capitalists congregate on Sand Hill Road behind Stanford campus -- no benefit to Stanford.

7. Singapore: Raffles Place
Financial Centers
Externalities
London: The City
New York: Wall Street
Hong Kong: Central
Singapore: Raffles Place
(c) , Ivan Png
Very concept of financial center implies externalities;
externalities among service providers --> concentrate in one location
Opposing concept:
get closer to customers  disperse all over the country.
Question: can telecommunications and IT provide same “closeness” without physical proximity?
closeness to other service providers
closeness to customer

8. Resolving Externalities
Economic inefficiency ® opportunity for profit
merger
collective action
When the sum of the marginal benefits is not equal to the sum of the marginal costs
a profit can be made by resolving an externality
profit opportunity disappears when externality is resolved (sum of the marginal benefits equals the sum of the marginal costs)
Merger: doesn’t matter whether source buys recipient of externality, or vice versa
Example: Disneyland
Anaheim: bought hotels around theme park;
Hong Kong: theme park will have authority to exclude aircraft and ships from peeking at fireworks.
Collective action: standards for telecoms and Internet
GSM --> 3rd generation
IEEE standards committees

9. Intel Inside
Externalities
Cooperative advertising resolves positive externality from one retailer to other retailers
(c) , Ivan Png
Compaq frequently advertises its products with the “Intel Inside” label;
potential generates externality for other PC manufacturers using Intel microprocessors
Intel resolves the positive externality through cooperative advertising.
Another example: advertisements by travel agents featuring airlines -- Cathay Pacific, Singapore Airlines, British Airways;
these advertisements benefit other travel agents and also the airlines
airlines should provide cooperative advertising payment to resolve the externality

10. Network Externality
Externality where benefit/cost depends on total number in network
English language
Internet
international telephone service
Network externality need not necessarily be related to service provided through network;
English language: Why is it so useful to learn English? Because so many other people speak and use it -- size of benefit/cost depends on total number in network;
Similarly with Internet and international telephone service

11. Network Effect benefit/cost depends on total number in network
through market, not directly conveyed
resolved by producer or service provider
Network effect
If you are the only person in the world with a telephone, who do you call?
Similarly with MSN Messenger
Difference from network externality: in case of network effect, someone resolves the externality -- the market achieves economic efficiency or approximates
Telephone service: service is concentrated, as of Feb 2001, only 3% of US users had choice of telephone service provider; provider will price relatively low, to stimulate subscribers and hence network effects, because it will capture the additional subscribers
Microsoft resolves network effect surrounding MS-Excel: prices relatively low so that more will use and generate benefit to other users
Similarly, AOL, Yahoo and others provide free Instant Messenger service
Contrast network externality – unresolved by market, so possible role for government
Example -- Internet access. Provision of service is fragmented. If one provider prices low to stimulate demand, the the additional subscribers may join other providers – original price cutter is just generating an externality for other providers.

12. Critical Mass
definition: number of users at which demand becomes positive
Critical mass: examples
Telephone service – Telephone companies understand the importance of critical mass. Long ago, AT&T advocated the concept of “universal service”
MSN Messenger – Little demand because so few people have this service; most people subscribe to AOL Instant Messenger, which is incompatible.

13. Network Effects: Demand Elasticity
highly elastic around tipping point
highly inelastic at low demand levels
Consider history of Microsoft Word vs WordPerfect:
Microsoft invested heavily to achieve critical mass of users – demand very inelastic when MS user base was low
after long and expensive investment, MS got close to tipping point
WordPerfect missed transition from DOS to Windows, then quickly collapsed – demand very elastic around tipping point
Tipping: tendency for the market demand to shift toward a product that has gained a small initial lead
Contrast demand for office productivity software like MS-Word and conventional products, eg, car stereo systems:
demand for car stereos is conventional – no tipping point between brands, competing brands can co-exist for long period of time

14. Public Good
Non-rival consumption -- one person’s increase does not reduce quantity to others
extreme economy of scale
Public good = provides non-rival consumption/usage.
eg, radio broadcast
other examples:
all forms of knowledge – scientific knowledge, artistic creation
national defense
Good that provides non-rival consumption yields extreme economy of scale – cost of serving 1 million users is same as cost of serving one.
Government provides both
public goods, eg immunization, national defense,
private goods, eg, nursing care, legal aid, education
Not all goods and services provided by government are public goods

15. Television Distinguish content delivery
Externalities
Distinguish
content
delivery
(c) , Ivan Png
Information technology, telecommunications, and media industries consist of three layers:
content, eg, business-to-consumer commerce, information, entertainment
service (Internet access and service)
infrastructure
Within content layer, information (eg, weather, news, images) is public good – just like knowledge;
but compare delivery mechanisms
newspaper
radio
television
Internet
Are they public goods?

16. non-rival consumption
Rivalness
congestible
public good
private good
rival consumption
non-rival consumption
Consumption is congestible: one person’s increase in consumption by some quantity reduces the total quantity available to others but by less than that quantity
bridge or tunnel at peak hour
Internet during busy period
Services of infrastructure may be public good or congestible depending on demand

17. Efficiency in Public Good10
8.9
vertical sum of marginal benefits
5.6
Marginal benefit/cost ($ per minute)
marginal cost 5
Alan
4.5 4
3.6
Mary
At the economically efficient provision (benchmark) of public good,
sum of marginal benefits = marginal cost
Similarly, as with externality, when the sum of the marginal benefits is not equal to the marginal cost
a profit can be made by resolving an externality
profit opportunity disappears when externality is resolved (sum of the marginal benefits equals the marginal cost) 1
Peter
0.8 1 4 5 10
Minutes of fireworks

18. Excludability Provider can exclude particular consumer law technology
Many public goods also have another aspect – difficult to exclude particular consumers
broadcast television
national defense
However, conceptually, two concepts are different
nonrival consumption
excludability – depends on law and technology

19. Excludability: Law patent – product or process
copyright – artistic expression
Law of intellectual property creates property rights  right to exclude particular person from consuming/using the item;
Astra has patent on ulcer drug, Losec  monopoly power  incentive for research and development
Oracle has copyright over database systems

20. Intellectual Property
Externalities
trade-off
benefit from usage
incentive for future creation
(c) , Ivan Png
Scientific concepts and new ideas are public good
more usage  greater benefit at no additional cost, so ideally, let everyone use freely
need to give incentive to scientists and writers, so give them intellectual property and they will set price to exclude some users

21. Discussion
Let b represent marginal benefit and q the amount of Sogo’s investment in the new ZhongXiao Fushing store. Suppose that the investment generates marginal benefis, b=10-q for Sogo, b=4-0.4q for the florist, and b=1-0.2q for the shoe store. Given the marginal cost of 1, calculate the profit-maximizing quantity of Sogo’s investment and the economically efficient quantity of Sogo’s investment.